Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 6

Forward and Futures Contracts

Introduction

To understand forward and futures contracts, we begin our discussion with an illustration of a spot transaction. Assume that it is May 15, 20XX, and we wish to buy 100 shares of IBM. We will go to an exchange such as the New York Stock Exchange (NYSE) and place a buy order for 100 shares of IBM stock. The order will be matched with a sell order placed by another party, assuming that a suitable counterparty is available, and a trade will be executed for 100 shares. Such a transaction is termed a cash or spot transaction. This is because as soon as a deal is struck between the buyer and the seller, the buyer has to immediately make arrangements for the cash to be transferred to the seller, while the seller has to ensure that the right to the asset in question—in this case, shares of IBM—is immediately transferred to the buyer.

Consider a slightly different situation. Assume that on May 15, 20XX, we wish to enter into a contract to acquire 100 shares of IBM on August 15, 20XX, and that a counterparty exists who is willing to sell the shares on that day. If so, we can enter into a contract that entails the payment of cash on August 15 against delivery of shares on the same day. The difference as compared to the earlier transaction is that no money need be paid by the buyer at the time of negotiating the contract, nor does the seller need to transfer rights to the underlying asset on that day. The actual exchange of cash for the asset ...